Magazine article Business Credit

Identifying Bankruptcy Risk

Magazine article Business Credit

Identifying Bankruptcy Risk

Article excerpt

In many cases, credit managers can easily predict corporate bankruptcies. Quite simply, a company declares bankruptcy because it does not have adequate capital to fund operations and remain solvent. Often, bankruptcy is the result of taking on too much risk, and this will be evident in a fundamental analysis of the financial statements, lt stands to reason that a corporation's public disclosure would provide ample warning of a high risk of bankruptcy ... except when it doesn't.

Indeed, among the 20 largest public company non-financial bankruptcy filings since 1980, nearly half were accused by regulators of manipulating their earnings to create the impression of a healthier company. And among those in the highly-leveraged financial services industry, whether or not they actually declared bankruptcy, the speed at which recent banking institutions fell from grace and the inability of the marketplace to value their assets gives one pause for concern as to whether the traditional ways of gauging bankruptcy risk has effectively protected stakeholders.

In the case of Lehman Brothers, in August 2007, the bank announced it would eliminate its subprime lender BNC Mortgage. After the announcement, the stock price dropped a mere 34 cents to $57.20. On September 10th of the following year, Lehman's share price was $4.22, and five days later it became the largest bankruptcy filing ever.

Famously, hedge fund manager David Einhorn, who had a short position on Lehman Brother's stock, questioned the bank's valuation just months prior to the firm's collapse, to which Lehman's CFO said "had no basis in fact."

Shortly after Lehman declared bankruptcy, Washington Mutual did as well, making it the second largest filing in history. Since that turbulent time, bankruptcy filings have only increased. In fact, the number of business bankruptcy filings during the first six months of this year rose 64% over the same period in 2008, according to U.S. Bankruptcy Courts. Chapter 11 reorganization filings were up 113% over 2008, while Chapter 7 liquidation filings increased by 57%.

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Clearly we've entered into a new era of bankruptcy risk. With an increase in the number of bankruptcies and the changing nature of company failures--driven by risks related to financial instruments and the speed in which companies decline--traditional approaches to identifying bankruptcy risk should be challenged to determine the best approach in this new environment. Economic pressures like the current recession and competitive changes such as new technology can significantly accelerate bankruptcies.

There are a number of broadly accepted bankruptcy models commonly used by corporate credit officers to gauge their exposure, both academic and practical, which are based on accounting factors that have been found to be predictive of bankruptcy. Measures of liquidity, leverage and profitability have formed the basis for these accounting-based bankruptcy models, the best known of which are the Altman Z-Score and the Ohlson O-Score. Accounting-based models are viewed as largely static, updated after annual or quarterly financial data is made available.

An alternative to static accounting-based models is a market-based approach. Market-based models have been found in academic research to provide a measure of bankruptcy risk as effective, or more effective, than accounting-based models. Market-based risk models are based on the option-pricing theories of BlackScholes and Merton's Distance to Default (DD). …

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